Securities Law Blog

According to a published report in Investment News, a Florida Senate bill that would levy heavy penalties on agents and financial advisers who make fraudulent annuity sales has moved closer to becoming law. The Safeguard our Seniors Act, or SB 1372, on April 2, 2009 moved to Florida’s Policy and Steering Committee on Ways and Means, placing it a step away from a full Senate vote.

Under the bill’s original provisions, which would apply to consumers over age 65, surrender periods — the length of time the investor must hold the annuity — would have been cut to five years. It also set the maximum surrender fees, which investors must pay for exiting the product too soon, at 5% and reduced the fee 0% by the end of the fifth policy year. Additionally, the original bill also extended the free-look period to 60 days from the normal 14-day limit. In its new form, however, legislators have loosened the restrictions on the annuity sales, allowing for surrender charges to go as high as 10%, with the charge to fall by one percentage point each year, so that there is no surrender fee at the end of the 10th policy year.

Under the revised bill, the surrender fee changes don’t apply to accredited investors, defined as individuals with a net worth of greater than $1 million or with an annual income of more than $200,000 in each of the past two years, or $300,000 a year in joint income. The amended bill also cuts the free-look period to 30 days. The original bill also made “twisting” and “churning” annuities a third-degree felony punishable by up to five years in prison. The penalty has been expanded so as to cover fraudulent conduct in connection with the sales of all financial products. The American Council of Life Insurers in Washington, the Florida chapter of the Falls Church, Va.-based National Association of Insurance and Financial Advisors and the National Association for Fixed Annuities of Milwaukee had combined efforts to fight the early version of the bill. NAIFA-Florida had also asked state finance chief Alex Sink to consider a maximum 10-year surrender period and 10% surrender charge limit.

The Internal Revenue Service finally offered guidance this week to Ponzi scheme victims that it would allow them to claim a tax deduction related to the bulk of their losses-even losses related to ficticious profits carried on phony statements. The matter has been a point of debate and anxiety for many of the victims I have spoken to over the last few weeks, given the lack of clarity in the tax code about how it should be handled.

The plan, which applies to victims of all Ponzi schemes, is likely to provide major relief to victims of Mr. Madoff. It is also likely to provide clarity for victims as they prepare to file federal income tax returns by the April 15 deadline, and help the I.R.S. avoid an unwanted avalanche of amended returns from victims.

The commissioner of internal revenue, Douglas Shulman, announced the plan in testimony before a Senate Finance Committee hearing on Ponzi schemes, tax evasion and offshore banking fraud. Later, in a briefing, Mr. Shulman said that “clearly the Madoff case is tragic as so many people were victims of this fraud, but the case also raises a staggering array of tax issues.”

Under the plan, the I.R.S. will allow investors, including those who are suing Mr. Madoff, to claim a theft loss equal to 95 percent of their investments, minus any withdrawals, reinvested gains and payouts from SIPC. Investors who are suing third-parties involved in such a scheme, and who, as a result, may have some prospect of recovery, are permitted to claim a deduction equal to 75 percent of their investments.

Current theft loss rules typically allow losses to be carried back three years and forward 20 years, but the I.R.S plan will allow carrybacks of as many as five years, generally if the loss is for a small business with gross annual receipts of less than $15 million. Under the plan, investors must claim the loss as having happened in 2008.

For people who invested with Mr. Madoff through retirement plans, like 401(k)s and individual retirement plans, the picture is more complicated because such money was already invested on a tax-free basis. Mr. Shulman, the commissioner, said that generally, if the investment was deductible when it was made, such investors “can’t take a loss.”

When computing losses, investors are not permitted to include any taxes they paid on what turned out to be fictitious income.

But the plan affords relief to such investors by allowing them to include fictitious income in their loss computations — a measure that might allow them to recoup taxes paid. It also will keep scammed investors from “owing taxes on income that they never received,” said Senator Charles E. Schumer, Democrat of New York and a member of the Senate Finance Committee. Presumably, Investors will need to produce copies of the fraudulent statements to show Madoff's phony inflated account values.

People who invested with Mr. Madoff through so-called feeder funds that placed client money with him will also get relief. These funds will be allowed to claim the theft-loss deduction but will allot those losses proportionally to individual investors.

The I.R.S. said it did not know how much money in taxes investors had paid in recent years on Madoff-related income. It said that investors who had already filed 2008 returns should file amended returns claiming the theft-loss deduction.

Bernie Madoff's accountant was arrested on fraud charges Wednesday as authorities blamed him for failing to make the most basic auditing checks that would have exposed an epic fraud that cost investors billions of dollars.

David Friehling is the first person to be arrested in the scandal since Madoff turned himself in, and his prosecution signals that the government is intent on bringing Madoff's associates to justice as they try to figure out who helped him carry out the fraud.

According to prosecutors, the 49-year-old Friehling essentially rubber-stamped Madoff's books for 17 years, serving as Madoff's auditor from 1991 through 2008 while operating from a discreet building in suburban New York.

Authorities said that if Friehling had done his job, Madoff's financial statements would have shown his company owed tens of billions of dollars to his customers and was insolvent.
"Mr. Friehling's deception helped foster the illusion that Mr. Madoff legitimately invested his clients' money," said acting U.S. Attorney Lev L. Dassin.

The relationship between the accountant and Madoff was so cozy that Friehling and his family pulled $5.5 million from accounts with Madoff since 2000 and had a balance of more than $14 million as recently as November. Prosecutors said it's a conflict for accountants to have such large sums invested with clients.

Friehling did not comment as he left the courthouse after being released on bail
Prosecutors now believe that Madoff received help--even if only in the category of malfeasance as opposed to misfeasance--from Friehling as he carried out his fraud, although Friehling is not charged with knowing about his Ponzi scheme.

The government says Friehling did not meaningfully audit Madoff's business or confirm that securities purportedly held by Madoff's company on behalf of its customers even existed.
The Securities and Exchange Commission said Friehling instead pretended to conduct minimal audit procedures of certain accounts to make it seem he was conducting an audit and then failed to document his purported findings and conclusions as he was required to do.

Prosecutors said he even failed to examine a bank account through which billions of dollars flowed.

"He did little or no testing, no verification of the `facts' he certified," said Joseph M. Demarest, head of New York's FBI office. "His job was not merely to rubber-stamp statements he didn't verify."

The SEC said Friehling took steps to hide his personal investment with Madoff, including replacing his own name on his Madoff account with his wife's name and later naming the account the "Friehling Investment Fund" to conceal the conflict of interest.

The SEC also accused Friehling of lying to the American Institute of Certified Public Accountants for years, denying he conducted any audit work, because he was afraid that his work for Madoff would be subject to peer review.

The accounting industry organization said Wednesday it had completed its ethics investigation of Friehling's conduct as an auditor of a brokerage firm and had expelled him for "failure to cooperate."

If convicted, Friehling faces up to 105 years in prison. He is charged with securities fraud, aiding and abetting investment adviser fraud and four counts of filing false audit reports with the SEC.
The fraud charges against Friehling come just days after the founder of his auditing firm, Jerome Horowitz, died of cancer last week at the age of 80, a family friend said.

Horowitz handled Madoff's books for many years before turning the business over to Friehling, who is his son-in-law.

The Securities and Exchange Commission recently took emergency action and obtained an asset freeze against two New York residents and their three affiliated entities, who allegedly orchestrated a brazen investment fraud involving the misappropriation of as much as $554 million in investor assets.

The SEC alleges that Paul Greenwood and Stephen Walsh promised investors that their money would be invested in a stock index arbitrage strategy. Instead, Greenwood and Walsh allegedly treated their clients' investments as their personal piggy bank to purchase multi-million dollar homes, a horse farm and horses, luxury cars, and a large Steiff teddy bear collection. The SEC obtained an emergency court order freezing the assets of Greenwood and Walsh as well as their companies: WG Trading Investors, L.P. (WGTI), which is an unregistered investment vehicle; WG Trading Company, Limited Partnership (WGTC), which is a registered broker-dealer located in Greenwich, Conn.; and Westridge Capital Management, Inc. (Westridge), which is a registered investment adviser located in Santa Barbara, Calif.

According to the SEC's complaint, filed in federal court in Manhattan, the SEC alleged that Greenwood and Walsh have been orchestrating the fraudulent investment scheme through their affiliated entities since at least 1996. The SEC alleges that they solicited a number of institutional investors, including educational institutions and public pension and retirement plans, by promising to invest their money in an "enhanced equity index" strategy that involves purchasing and selling equity index futures and engaging in equity index arbitrage trading. However, Greenwood and Walsh have been misappropriating hundreds of millions of dollars of investor funds for their personal use instead of investing the money in the enhanced equity index strategy. In fact, Greenwood and Walsh misappropriated as much as $554 million of the $667 million that Westridge clients invested in WGTI. Greenwood and Walsh have provided some of the investors' money to their spouse and ex-spouse, respectively, who are also named as relief defendants in the SEC's complaint.

As reported this morning on Bloomberg, Bernie Madoff has been led to jail in handcuffs after pleading guilty-something his victims have been awaiting for weeks. The Bloomberg story follows:

Madoff Is Guilty in Ponzi Scheme; Ordered to Jail

By David Glovin, David Voreacos, and Patricia Hurtado

March 12 (Bloomberg) -- Bernard Madoff was jailed after admitting he masterminded the largest Ponzi scheme in history, an epic swindle that may have reached $65 billion and made him the symbol of investor distrust in a global recession.

Madoff, 70, entered his guilty plea in Manhattan federal court three months after confessing to relatives that his firm, Bernard L. Madoff Investment Securities LLC, was “one big lie.” U.S. District Judge Denny Chin ordered that Madoff, who has been free on $10 million bond, should be jailed while awaiting sentencing, scheduled for June 16. He faces as much as 150 years in prison.

“I never invested the funds in securities as promised,” Madoff told Chin at a hearing today in a courtroom packed with victims and members of the media. He said he was “deeply sorry” and knew what he did was criminal.

Madoff told Chin that in the early 1990s, when the U.S. was in a recession, he felt “compelled’” to provide the returns he promised investors. He said when the Securities and Exchange Commission asked about it, he lied to the SEC.

Madoff’s guilty plea -- he repeated the word 11 times this morning -- marks the downfall of a once-acclaimed money manager who told the world his fortune came through an eponymous firm that specialized in making markets, trading securities and advising wealthy clients.

Client Roster

Over three decades, he built a reputation as a brilliant stock picker who delivered steady returns through both bull and bear markets, attracting an international client roster that included celebrities like filmmaker Steven Spielberg, fund managers like J. Ezra Merkin, charities, universities, friends, and even royalty.

Some of the thousands of his investors lost their life savings. Thierry Magon de La Villehuchet, chief executive officer of Access International Advisors, which managed $3 billion, was driven to suicide because of his firm’s Madoff- related losses, his brother, Bertrand Magon de la Villehuchet, said in January.

The scandal has cast scrutiny on the Securities and Exchange Commission, whose chief, Mary Schapiro, pledged to beef up staff and expedite enforcement cases. Harry Markopolos, a former money manager, told Congress that he tried to persuade the agency for nine years that Madoff was a fraud, and that most agency officials he dealt with suffered from “investigative ineptitude.”

No Deal

The case doesn’t end with Madoff’s plea. Investigators have seized control of his offices at the lipstick-shaped building at 885 Third Avenue in Manhattan, where Madoff Securities operated out of three floors. Prosecutors say his subordinates helped him swindle investors. A central issue for investigators is whether employees knew of the fraud. No one else has been charged.

Madoff didn’t sign a plea deal that would have granted him leniency or other consideration in exchange for cooperation with the government. He was forced to plead guilty to all 11 counts against him because he refused to admit to a conspiracy, a charge that would have required him to disclose co- conspirators, according to people familiar with the case.

Prosecutors are hunting for Madoff’s assets, as they seek forfeiture of the $170 billion they said moved through Madoff Securities since the fraud began in the 1980s. The firm’s bankruptcy trustee has found about $1 billion in cash and securities.

4,800 Investors

Madoff told 4,800 investors in November that their accounts held $64.8 billion, though their holdings were a “small fraction” of that, prosecutors said in court papers. Defense attorney Ira Sorkin said it’s unclear how much investors lost.

Madoff pleaded guilty to securities fraud, mail fraud, wire fraud, investment adviser fraud, three counts of money laundering, false statements, perjury, false filings with the SEC and theft from an employee benefit plan.

His scheme unraveled in early December amid a rush of investor redemptions, the government said. On Dec. 9, he told his sons Mark, who ran Madoff’s proprietary trading business, and Andrew, who was a director of the unit, that he wanted to pay bonuses two months earlier than usual, according to prosecutors.

There was “absolutely nothing,” and the business was “all just one big lie,” Madoff told his relatives, according to an affidavit filed in court on Dec. 11 by Federal Bureau of Investigation Agent Theodore Cacioppi.

Arrest

The sons turned their father in to federal authorities, according to their lawyer, Martin Flumenbaum. Neither is accused of any wrongdoing.

Madoff was arrested Dec. 11 and charged with one count of securities fraud for using billions of dollars from new investors to pay off old ones at his firm. Dogged by news cameras as he traveled to and from court, Madoff was allowed to remain free on $10 million bail and ordered to remain in his multimillion dollar apartment on Manhattan’s Upper East Side, under electronic and video surveillance and watched over by security guards.

The scheme centered on Madoff’s claim to investors that he used a “split-strike conversion strategy” in which he promised to invest in stocks that mimicked the price movement of the Standard & Poor’s 100 Index, while “opportunistically” timing purchases, Acting Manhattan U.S. Attorney Lev Dassin said.

Madoff promised some investors returns of up to 46 percent and “created a broad infrastructure” to give the appearance of “a legitimate investment advisory business,” prosecutors said in court papers. His back-office staff had little or no experience and at Madoff’s direction misled clients about investments, the government said.

Manhattan Apartment

Madoff is being sent first to the 12-story Metropolitan Correctional Center in lower Manhattan, federal marshals said. Later he may be assigned to one of several U.S. facilities in the New York area, including the Federal Correctional Institution in Otisville, New York.

Madoff is joining a corps of aging white-collar convicts including former WorldCom Inc. Chief Executive Officer Bernard Ebbers, 67, now housed at the Federal Correctional Institution in Oakdale, Louisiana, and John Rigas, 84, the ex-CEO of Adelphia Communications Corp. who is imprisoned at the Federal Correctional Institution in Butner, North Carolina.

Last week, a different judge said in court papers in a related lawsuit by the SEC that Madoff’s lawyers claim that Madoff’s wife, Ruth, is the sole owner of the couple’s Manhattan apartment, $45 million in bonds and $17 million in cash. These assets are “unrelated” to Bernard Madoff’s alleged fraud scheme, his attorneys said, according to the judge.

It may ultimately be left to Chin to decide whether Ruth Madoff may keep the assets. She hasn’t been charged with a crime.

The criminal case is U.S. v. Madoff, 09-cr-00213, U.S. District Court for the Southern District of New York (Manhattan).